With an ROE of 21.88%, Alimentation Couche-Tard Inc (TSX:ATD.B) outpaced its own industry which delivered a less exciting 16.99% over the past year. But what is more interesting is whether ATD.B can sustain this above-average ratio. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. Check out our latest analysis for Alimentation Couche-Tard
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of ATD.B’s profit relative to its shareholders’ equity.An ROE of 21.88% implies $0.22 returned on every $1 invested, so the higher the return, the better.Investors seeking to maximise their return in the Food Retail industry may want to choose the highest returning stock.However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. ATD.B’s cost of equity is 8.49%. Given a positive discrepancy of 13.39% between return and cost, this indicates that ATD.B pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses.The other component, asset turnover, illustrates how much revenue ATD.B can make from its asset base.The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage.ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at ATD.B’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 60.90%, which is reasonable. This means ATD.B has not taken on too much leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.
ROE – More than just a profitability ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. ATD.B’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. However, there are other crucial measures we need to account for before determining whether or not its returns are sustainable. I recommend you see our latest FREE analysis report to find out more about other measures!
If you are not interested in ATD.B anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.